Ideally, an insurance policy holder pays to his insurance company a premium which is a cost for a period of insurance coverage whose magnitude is proportional to his insurance claim(s), also known as losses. A loss ratio, which is a ratio of loss(es) to premium(s), is an effective measure of premium pricing. For example, if a policy holder has losses of $800 and is charged $1000 in premiums, then the loss ratio for the policy holder is : EQU 800/1000=0.80 (1)
Similarly, if a policy holder has losses of $400 and is charged $800 in premiums, then the loss ratio for the policy holder is: EQU 400/800=0.50 (2)
The first of the above two loss ratios, 0.80, is greater than the second loss ratio 0.50. Accordingly, the first loss ratio indicates a policy holder who is charged too little for his premiums with respect to the second policy holder, who is charged too much for his premiums. Similarly, a group of policy holders has a loss and a premium. The loss of a group is a sum of losses of policy holders in the group, and the premium of a group is a sum of premiums of policy holders in the group.
In the highly competitive insurance industry, companies compete for clients by offering lower premiums. As a result, some policy holders who are responsible for high losses are charged too little for premiums. Other policy holders with low losses must then pay high premiums to compensate for those with high losses. An insurance company which charges a policy holder high premiums cannot expect to retain that policy holder if other insurance companies will charge the policy holder lower premiums. Low loss ratio policy holders, like the second policy holder in the above example, are likely to switch to another insurance company which will charge them lower premiums. Thus, an insurance company will tend to lose customers who have low loss ratios while retaining those with high loss ratios. This leads to the undesirable situation of having only policy holders which incur high losses. An insurance company with mostly high loss clients will pay its clients large amounts of money in insurance claims, leaving less money for the insurance company to retain. Furthermore, an insurance company will have to raise premiums to cover the large amount of claims, causing even more policy holders to switch.
To retain the more desirable low loss policy holders, insurance companies establish a desired average loss ratio, which is the ratio of losses of all policy holders to premiums of all policy holders. For example, if an insurance company sets the desired average loss ratio to 0.60, then each policy holder should have a loss ratio of 0.60. Where a first policy holder has losses of $800 and a second policy holder has losses of $400, their respective premiums P1 and P2 would ideally be set so that: EQU $800/P1=0.60 (3) EQU $400/P2=0.60 (4)
Thus, solving for P1 and P2, the premium of the first policy holder would be $1333.33 and the premium of the second policy holder would be $666.67. It is further apparent that if an insurance company successfully establishes a desired average loss ratio, the average loss ratio represents a portion of the total premiums which the insurance company pays out in losses. For example, if the average loss ratio for all policy holders is 0.60, then the insurance company pays out 60% of all premiums to policy holders in the form of losses. The insurance company consequently retains the remaining 40% of all premiums received from policy holders.
Though an overall average loss ratio may be established, in general loss ratios of given groups of policy holders exceed the average loss ratio, while other loss ratios of other groups of policy holders are below the average loss ratio. A group with an above average loss ratio is underpriced, or pays too little in premiums in light of the losses sustained by the group. Similarly, a group with a below average loss ratio is overpriced, or paying too much in premiums. Thus, premiums for groups with higher than average loss ratios should be increased, and premiums for groups with lower than average loss ratios should be decreased in order to obtain equal loss ratios among all groups. Groups of policy holders with above average or below average loss ratios indicate that the insurance company has not successfully predicted the losses of a policy holder based on his characteristics.
Though insurance companies generally prefer to establish a uniform loss ratio for all policy holders, there are situations where allowing a group to have a higher than average loss ratio is a desired business strategy. For example, if an insurance provider is attempting to attract a certain group, the insurance provider may want to charge the group lower premiums than would normally be expected in light of the expected losses of the group. The lower premiums result in a loss ratio of the group which is higher than an loss ratio average.
Regardless of the particular business strategy, it is desirable to provide a loss system which successfully establishes a desired average loss ratio for policy holders. If a given control system does not successfully establish a desired average loss ratio for policy holders, groups of policy holders will have higher loss ratios than desired, indicating that the groups are paying lower premiums than desired. Crucial to establishing a desired average loss ratio is an ability to predict losses of a policy holder so that a premium can be determined accordingly. Insurance companies use a classification plan to predict losses of existing and potential insurance policy holders based on policy holder characteristics obtained by application, questionnaire, credit check and other factual inquiries. A classification plan uses known characteristics of a policy holder to determine the likelihood that the policy holder will submit claims to the insurance company, thereby incurring losses. A classification plan is also used to determine an expected size of claims based on known characteristics of the policy holder. An insurance company which does not accurately predict losses of a policy holder, probably uses a classification plan which does not appropriately utilize known characteristics of the policy holder.
It would be advantageous to provide a system which identifies policy holders which are underpriced or overpriced, i.e. paying too little or too much, respectively, in premiums.
It would also be advantageous to provide a system which improves a classification plan so that the classification plan better predicts the losses of a policy holder based on the known characteristics of the policy holder.
Furthermore, it is often difficult to determine whether improvements to a classification plan are optimal, or whether further attempts to improve the classification plan will actually provide additional improvements. It would be advantageous to provide a system which determines whether an optimal classification plan has been generated.